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CLOs: Buy in May?

June 1, 2017 - CLO issuance continued to trend solidly in May, approaching $10 billion in the U.S. and topping €2 billion in Europe. But while issuance continued to recover, other volume trends began to shift. For instance, Deutsche Bank tracked $6 billion of U.S. CLO refis in May, marking the first month in 2017 where refis lagged new issue volume.  All told, year-to-date U.S. CLO issuance has hit $37 billion, up 91% over the same (anemic) period in 2016, but down 20% from 2015 levels.

So where does CLO volume go in 2017? Speakers at the IMN Conference last week suggested that CLO issuance could climb as high as $90 billion. However, lofty issuance hopes could be constrained by limited real loan issuance and a challenging arbitrage. Cases in points: Loan outstandings in the S&P/LSTA Leveraged Loan Index have increased only $20 billion this year. Meanwhile, CLOs’ asset-liability arbitrage has compressed from 340 bps a year ago to 255 bps in late April, according to BAML research. In turn, many CLOs are seeing pressure on their Weighted Average Spread (“WAS”) tests; if a CLO fails its WAS test, its ability to buy new collateral may be constrained. 

In light of these challenges, what happens to CLO activity this year? First, refis are expected to ebb. Most 2017 CLO refis have been done under the auspices of the Crescent No Action Relief letter. Crescent refinancings are i) limited to CLOs issued prior to December 24, 2014, ii) must be done within four years of issuance, and iii) cannot change anything except the CLO note spreads. So while these refis improve the arbitrage (and, hence, equity returns), they do not extend reinvestment periods, nor do they change the WAS test. Thus, they still leave the refinanced CLO at risk of failing the WAS test.  Moreover, as the Crescent letter only permits one refinancing within four years of issuance and more than $65 billion of CLOs already have refinanced this year, the refi window is narrowing. 

Resets – which, at $12.5 billion year-to-date, have materially lagged refis – may be ascendant in the second half. With new collateral scarce, a reset permits an equity investor to recycle assets into a quasi-new CLO. Like a new deal, the reset CLO has a longer reinvestment period. (Of course, it also requires the manager to retain risk.) Like a refi, the reset will have lower cost of capital than the original CLO, improving the asset-liability arbitrage. But a reset also can change the WAS test, removing the threat of failing the test.  For all these reasons, market participants see resets overtaking refis in the second half of 2017.

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